Election results from Japan give a landslide victory to the opposition Democratic Party of Japan (DPJ) in the national polls for the lower house (Diet). Out of the total of 480 seats contested, the opposition has won 308 seats. It is a comprehensive victory. For the first time since World War II, the Liberal Democratic Party (LDP) will not rule Japan. It seems appropriate after the unemployment rate went up to 5.7% in July, a post-World War II high.
In fact, most of the monthly data released on Friday showed up the so-called economic recovery in poor light. Household spending contracted, the unemployment rate went up, the number of jobs available per applicant shrank and deflation remained entrenched. The ruling party had proclaimed an end to the economic slowdown before the elections to boost its electoral fortunes. But, the data did not back it up eventually.
The annual Article IV consultations of the International Monetary Fund (IMF) with Japan made the following statement about the importance of small and medium enterprises (SMEs) for Japan: “SMEs account for over 50% manufacturing shipment and 25% of exports and investment. They span many industries (e.g., 90% are in services) and historically have served as key suppliers to large manufacturing firms. SMEs account for nearly 70% of employment and in recent years have been a major source of jobs for the economy.”
However, they suffer from high leverage (especially in the services sector) and lower access to funding. Thanks to some proactive measures taken by the Bank of Japan and the banks’ relatively limited exposure to US securities, bank lending had continued to rise throughout 2008. The catch is that it was mainly to large enterprises. Loans to SMEs contracted.
Given this context, it was heartening to go through the manifesto of the opposition DPJ. It had devoted considerable space to the situation in SMEs. DPJ promises to reduce the corporate income tax on SMEs to 11% from 18%. Further, there is a promise to review the need for personal guarantees in lending to SMEs by government-related financial institutions and the joint and several liability system with a view to its possible abolition.
Similarly, DPJ has devoted considerable attention to the welfare of children. The allowance for a new child is to be raised, as is the subsidy for higher education. In sharp contrast to the practice in India, the manifesto provides an estimate of the fiscal costs of the promises and also offers specific matching spending cuts elsewhere.
Making it less costly for the public to have children is important as Japan faces a huge demographic challenge. IMF estimates that Japan’s medium-term potential growth rate has shrunk to around 1.0% from 1.75%. In fact, both IMF and Japanese authorities have acknowledged considerable uncertainty surrounding near-term growth prospects and that risks were mostly to the downside. IMF specifically mentioned deteriorating labour market conditions (which the July data had borne out), tight domestic financial conditions and external uncertainties.
Interestingly, even the one upside risk to growth is soft-pedalled. While faster-than-expected growth in China could bolster Japan’s manufacturing exports, IMF acknowledges that there is little import content in China’s fiscal stimulus. So, through the IMF staff assessment of Japan, one gets the Fund’s assessment that China had not done much to help global demand recovery.
In 2007, IMF had done a comprehensive analysis of Japan’s banking system, the exchange rate, the need for deregulation in the services sector, etc. The study on the exchange rate acknowledges the importance of capital flows in determining the proper (“equilibrium”) value of the exchange rate in addition to other traditional economic fundamental variables. In the short run, Japanese acquisition of foreign assets (capital outflows) depreciates the yen while in the long term, it contributes to yen appreciation. But it helps to perpetuate undervaluation in the relevant horizons for most investors—up to five years.
In the wake of the thumping victory of DPJ, it is possible that capital outflows reverse, leading to an appreciation of the yen and the stock market in Japan. Japanese stocks are relatively cheaper in Asia and considerably so compared with China. Given the party’s domestic and somewhat populist orientation, some view the party as being less averse to yen appreciation in the medium term. However, any pronounced appreciation of the currency in the short term would pose an early test of the party’s mettle in economic affairs.
That said, the margin of victory and the opposition party’s policy priorities augur well in the near term for Japanese stocks, at least in relative terms to rest of the developed world and in Asia, if not in absolute terms. Some firming of the yen, too, appears inevitable. A change in the economic fortunes of Japan for the better would make Asia a more interesting place to invest in.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org